Take medium-term bet on commodities

As manufacturing in China recovers, so will the demand for raw materials

There is global panic at the thought of a Covid-19 pandemic. That has provoked extreme action from the US Federal Reserve, which made an out-of-turn 50-basis-point rate cut for the first time after October 2008. The Fed Fund policy rate pair is down to a band of 1-1.25 per cent.

The Fed cut is likely to lead to copycat actions by other central banks, including the People’s Bank of China. Since US inflation is running at 2.5 per cent, this is a deeply negative real interest rate for America. Japan and the European Union have nominally negative rates already, and lower inflation.

Like everywhere else, sentiment in India too has been hit by coronavirus and the US rate cut. Weak Q3 GDP data (October-December 2019) has been discounted. This was the seventh successive quarter when growth stayed down, although Q3 was marginally better than Q2. The data for Q1 and Q2 (April-September 2019) were revised up, while the data for Q1 and Q2 2018-19 (April-September 2018) was revised down.

This is very unusual since Q1, Q2 data is usually revised only after full-year data comes in because that’s when unlisted firms and individuals file results and taxes. The net result of revisions seems to be meeting a GDP growth “target” of 5 per cent for 2019-20. February’s high-speed data is hard to compare year-on-year because of the extra working day. But consumption still seems down, since auto sales are weak.

The global economy has been disrupted by anti-epidemic measures. Trade has been impacted and supply chains broken. China seems to be over the worst but other nations, including Italy, South Korea, Japan and the US are now impacted.

The optimists are betting on the disease limiting itself in summer if the virus doesn’t survive high temperatures. Even if that turns out to be true, and there’s no guarantee, there may be at least another quarter of sub-par economic activity.

The Reserve Bank of India (RBI) faces a dilemma. India’s inflation is well above the upper limit of the target band of 2-6 per cent. That’s mainly due to food inflation. But food inflation usually doesn’t reduce in summer. A rate cut would be contraindicated, given inflation. But weak growth makes it tempting.
 

If the RBI maintains the current policy rate (it’s very unlikely to raise), the rupee may become more uncompetitive globally, since hard currency rates look to be trending down. On the other hand, the rupee has taken a beating in the past ten days and the RBI may want to shore up the currency.

From a foreign portfolio investor (FPI) perspective, India’s growth is low, equity valuations are high, and the currency is bearish. There has been heavy FPI selling in March, with over Rs 12,000 crore (equity and debt combined) divested by March 4. That money is flowing back into safe hard currency assets, and into more sustainable equity valuations in other markets. FPI selling is one reason why the rupee has dropped.

If FPI selling continues, there will be further pressure on the rupee. This brings us back to a theme we have mentioned several times before. Diversifying overseas into hard currency assets seems to make sense for domestic investors.  The currency gains alone would be worthwhile. Plus, if there is a continuing flight to safety, there would be major capital gains in US bonds.

If you are looking for a temporary, or medium-term trade, there is likely to be a big rebound in global commodities once China starts functioning at close to its full capacity again. It stands to reason that as the manufacturing hub of the world recovers, so will demand for the raw materials it consumes.

Such a bounce may, or may not, last. But there could be a 10-15 per cent surge in industrial metals like copper, iron ore and zinc prices from current levels if Chinese growth picks up. There could be a firming up of energy prices as well. Most analysts see the industrials and energy commodities space as overall bearish for 2020. But the fall in the first two months has been so steep that there is ample room for a bear market rally.  

Steel has seen unusual price swings. Global demand is down. But Indian steel manufacturers have hiked prices due to lack of Chinese supply. When China comes back into the market, Indian steel prices could slide.